Since 2011, my passion and focus has been keeping money out of the IRS coffers and in the pockets of taxpayers through proactive implementation of tax savings strategies. As I have said before, the tax code is full of tax breaks put there purposely by Congress. This month, I am focusing on ways for high income earners to slash the taxes they pay. Some people in mid-MO would be glad to have a net worth of $250,000, yet there are talented people that earn more than that every year. This article is for them.
Because the US Tax Code has graduated income tax rates (meaning the more you make the more you pay) finding a deduction for people in the top tax bracket will save them almost 4 times more in taxes than someone in the lowest tax bracket. The 2019 federal tax brackets range from 10% to 37%. (So, I trust you see my point.)
Here are four advanced tax savings strategies that apply only to unique situations.
- Cost Segregation, (Cost Seg).
- Charitable Remainder Annuity Trust (CRAT).
- Closely Held Insurance Company (CHIC, or Captive Insurance Agency (CIC))
- Conservation Easements (CE).
Cost segregation only benefits owners of real estate. Simply put, a Cost Seg study allows the owner of developed real estate to accelerate deductions to the current tax year. The study is produced by a specialized engineering firm. The result is the reclassification of significant portions of a building (which is depreciated over 39 years) to components with shorter useful lives that are depreciated over 5, 7 or 15 years. Because of the time value of money, a deduction today is worth much more than a deduction 39 years from now.
Let’s look at an example. Ignoring land and bonus depreciation, let’s assume you purchased a business condo for $1 million. Depreciation expense per year would be $25,641 ($1 million / 39 years). Now, let’s assume you discover Cost Seg in year 5. Let’s also assume that 40% of the building has been reclassified to 5-year property. The Cost Seg study allows you to move $400,000 from building asset to various 5-year components (such as Plumbing, HVAC, Electrical, Communications, Envelope, etc.). Correcting depreciation lives and rates for prior years is considered a change in accounting method. Therefore, you get to catch up on the higher depreciation that should have been claimed the first 4 years via a special adjustment this year.
Without Cost Seg your deduction for depreciation would be $25,641 per year which totals $128,205 for 5 years. Using Cost Seg you would claim an adjustment (additional deduction) of $348,720 in the current tax year! Using the top federal tax bracket, this would save you $129,026 in taxes this year. However, your future deductions for depreciation will decrease, but that is more than offset by having access to the money today.
Charitable Remainder Annuity Trusts (CRAT) have been part of the tax code since 1969. According to the plain meaning of Section 664 no taxes apply. See verbatim excerpt: “IRC Section 664, (c) Taxation of trusts, (1) Income tax, A charitable remainder annuity trust and a charitable remainder unitrust shall, for any taxable year, not be subject to any tax imposed by this subtitle.” In brief, CRATs are perfect for highly appreciated assets. Simply follow these steps. Form a CRAT, donate highly appreciated assets, wait a bit (to avoid the appearance of a prearranged sale) then the CRAT sells the assets and pays you a contractual amount each year. You also get a charitable deduction the first year.
A Closely Held Insurance Company (CHIC) is another tax savings strategy. It is also known as a Captive Insurance Company (CIC). When done properly, a CIC allows a successful business owner to take profits that would otherwise have been lost to taxes and set up a small insurance company. One key is to make sure there is a legitimate insurable interest. It is also important to avoid pitfalls by using an expert. The tax savings far exceeds the set-up expenses. Additionally, when the funds come back out, they are considered capital gains. In summary, you avoid ordinary income taxes by funding a new CHIC that you own, which provides insurance protection and returns funds at capital gains rates. This strategy is on the IRS radar recently because short cuts were taken by some self-described “experts” resulting in transgressions of the regulations.
Finally, Conservation Easements are very powerful tax savings tools for taxpayers who are motivated to preserve the natural beauty of this country. Rather than going after a few bad apples in the industry, the IRS worked with the Department of Justice to file a suit on 12/18/18 against promoters of certain Conservation Easements. The IRS doubled down in November 2019 by issuing IR-2019-182 promising to put an end to these “abusive tax schemes.” This must be a potent strategy if the IRS is rattling its saber so loudly. Congress is responsible for motivating taxpayers through tax breaks (like they have done for decades) to permanently conserve the beauty of nature for future generations. The IRS’s main attack is the use of LLCs and partnerships to facilitate the implementation of conservation easements. The IRS’s attention to this strategy and publication of their point of view, has definitely cooled the momentum of this strategy. So, in that respect, the IRS has already succeeded, even if they don’t win this case in court. However, my personal research and interviews with industry experts say the IRS has no case and this continues to be a powerful wealth preservation tool.
Aric Schreiner, CPA, PFS, Certified Tax Strategist, helps successful professionals and small business owners strategize to reduce taxes and audit risk.
